The Looming Uncertainty of the Mortgage Debt Relief Act

By: Lance T. Denha, Esq.

Anytime a lender writes off, or “forgives,” debt, it can be considered taxable income to the borrower. The larger the loan that is written off, the larger the potential tax bill that a taxpayer/homeowner may incur. Consider that every $10,000 in debt that is forgiven could incur as much as $1,500 to $3,500 in federal taxes depending on your tax bracket. Put another way, if your home is valued at $100,000 less than the existing debt and the debt is forgiven by the Lender, you as taxpayer could be responsible for a federal tax bill of up to $35,000, in addition to any state and local income taxes.

In recent years, most homeowners who have property that is worth less than the debt on the property, or commonly referred to as “underwater” or who lost property to a foreclosure or short sale were excused from having to pay taxes on this phantom income thanks in part to the Mortgage Debt Relief Act of 2007 (“The Act.”) The Act states that homeowners don’t have to include forgiven debt as income provided the following are all met:

1. The debt is secured by a principal residence. Mortgages on investment property or vacation homes don’t qualify.

2. The debt was “used to buy, build or substantially improve your principal residence, or to refinance debt incurred for those purposes.”

3. The maximum amount that could be treated a “qualified principal residence indebtedness” is $2 million, or $1million if married and filing separately.

The Act’s protections are scheduled to expire at the end of this year, however it’s not clear what Congress has in mind for renewing its terms. There was a suggestion by the Obama administration to extend the Act to 2014, however no clear direction has been given as of yet.

The scheduled expiration of the Act means uncertainty for many “underwater” homeowners who are currently in the process of foreclosure. More than 2 million people are currently in foreclosure, according to numbers maintained by Lender Processing Services. An additional 4 million mortgage holders are at least 30 days behind. If you’re early in the foreclosure process, though, it may already be too late to beat the December 31st expiration of the law, unless you arrange a deed in lieu of foreclosure. This process effectively involves a homeowner transferring the deed to the home in exchange for being released from debt. There is a potential downside here to acting too fast. Rushing to hand over your deed to your lender may be a mistake if Congress ends up extending the Act. Why? While lender forgiveness of debt is not automatically assured and a lawsuit may follow for deficiency, a thorough securitization audit may uncover errors by the lender, thus allowing for legal action and keeping your home. In effect, a homeowner could possibly have more time to discover other options for staying in his/her home.

As stated above, it should be noted that lenders still have the right to pursue a deficiency balance against the foreclosed homeowner even if the lender chooses to issue a 1099-C against the homeowner. A 1099-C is the tax form used by the lender to show a discharge and cancellation of debt against the homeowner. Should lenders choose to exercise this option to pursue a deficiency, homeowners need to be cognizant of the financial responsibilities and obligations which may follow. At the very least, you should consider all your options and perhaps consult an attorney or accountant so that an expert can help explain the situation.